Here comes Santa Claus, right down Santa Claus Lane….

What surprises could still lie ahead this Christmas?

The Federal Reserve delivered a dovish surprise at this week’s FOMC, prompting a further significant rally in global yields. During 2024, the Fed is expecting to lower rates by 75bps, on increased confidence that inflation is coming back to its 2% target. At the same time, the economy is expected to remain around full employment, with Powell essentially messaging that he has managed to deliver a soft landing, defying the sceptics.

In this context, it appears that Fed’s own views have moved quite a long way in the past couple of weeks. This is notwithstanding a robust labour market report last week, solid retail sales and a CPI print showing core inflation still at 4%, double the Fed’s objective.

It is also interesting to observe that having made a point of discussing the tightening of financial conditions seen ahead of the October FOMC, at this week’s press conference, the subsequent easing of financial conditions failed to get a mention. Indeed, with 2-year yields dropping by 40bps, credit spreads gapping tighter and equities hitting all-time highs, it is notable that the Fed has knowingly encouraged a further material easing in these indicators.

There may be some who wonder if the Fed is seeing something which others are not. Yet, it strikes us that having witnessed an 18-month period in which the Fed led the market, so it is possible now that Powell is happy to let the market lead the Fed.

Although we see dangers in this, it seems unwise to try to fight markets here. From a market perspective, it seems like the Fed has given a green light to risk assets and it would not be surprising to see strong price action into the end of the year and early January, as investors seek to increase beta exposures. Indeed, it is easy to see how markets could become quite frothy into the new year, without much of a policy pushback.

Economically speaking, we also wonder whether a boost to animal spirits could lead to an acceleration in economic activity rather than the slowdown many have been expecting. We would observe that it is also unusual to signal a move towards cutting rates, at a time when stock markets are at their highs and unemployment near its lows.

With wealth effects buoyant, the labour market robust and incomes rising, one also wonders whether inflation will decline as quickly as policymakers are hoping for. In our own assessment, we doubt that core inflation will drop below 3% before the second half of 2024. Services inflation remains relatively strong and unless the economy weakens, we doubt that this will decline soon.

In some respects, we might wonder whether history may judge the dovish pivot at this December’s FOMC to have been a mistake, should inflation remain problematic as we move into 2024. In this sense, the Fed is taking something of a gamble.

However, it seems that the temptation to win the mantle as the Fed Chair who pulled off a soft economic landing is outweighing the fear that Powell could go down as the next Arthur Burns, the Fed Chair who let inflation run away.

Regardless of whether history will judge the Fed as right or wrong, in the shorter term we think that running flat duration in US rates makes sense. We see valuations as unattractive across the curve, but risk/reward does not favour running an active position.

As for credit, we have been happy to add to exposure, where issuer performance has lagged, in both corporates and sovereigns. We are also left more constructive on EM local currency assets and see scope for the dollar to weaken somewhat further.

Over the past week, the yen has been a material outperformer as short yen carry trades are closed. We see scope for trend-following models, which have been selling yen, to also switch their positioning around and from this point of view, technicals in the Japanese currency also look relatively favourable.

Next Tuesday also sees the BoJ’s policy meeting, which has been the source of attention, since speculation mounted with respect to an end to Negative Interest Rate Policy (NIRP), at this meeting.

This week’s Tankan survey pointed to relatively upbeat economic prospects in Japan, and we remain convinced that Japanese policy rates will rise in the coming year, even as they decline in the US and Europe. A narrowing of policy rate differentials should help the yen to outperform, and we remain structurally constructive on the Japanese currency.

We have noted the strikingly cheap valuation of the yen and think that a rate closer to 130 versus the dollar would represent fairer value. However, timing in terms of BoJ policy shifts remains uncertain and we had thought that a shift in January was more likely than in December – partly to tie in with a revision to inflation and growth forecasts, per the BoJ quarterly meeting cycle.

That said, we have shared our views with Japanese policymakers that policy is currently behind the curve in Japan and that there is little to lose and much to gain by bringing forward steps towards policy normalisation. It also strikes us that the BoJ is also eager to scrap NIRP and exit Yield Curve Control, prior to the point when policy overseas is moving in the other direction.

The ECB meeting contained fewer surprises than the FOMC. The Governing Council has moved in a slightly more dovish direction in the wake of slowing growth and declining inflation, as reflected in recent comments from Isabel Schnabel.

However, we are inclined to look for CPI to increase into the new year and from that perspective we think that the ECB will only be in a position to cut rates in the second half of 2024. In comparison to the Fed, we see the ECB being more disciplined with respect to its 2% inflation target and we sense a degree of nervousness that much of the good news on declining inflation is now behind us. That said, 10-year bund yields have declined to 2%, in line with moves in Treasuries. Lower absolute yields levels have also helped to push peripheral spreads tighter.

To understand this, it is worth reflecting that debt sustainability concerns can become prevalent for a country such as Italy, as yields pushed towards 5%. However, with 10-year yields now around 3.75%, so these concerns are mitigated to a degree. In this way, we see spreads as positively correlated to movements in overall yield levels. Within the Eurozone, we continue to see value in Romania and Greece. Elsewhere, we are cautious about adding exposure, ahead of upcoming supply into the new year.

Relative to other central banks, the BoE was somewhat more hawkish at its Monetary Policy meeting. The MPC voted 6-3 to maintain rates at 5.25%, retaining a bias to hike. Although Bailey and colleagues project inflation and interest rates declining in 2025, for the time being, there is a level of concern with respect to inflation and wages.

Core CPI in the UK remains close to 6% and with the UK Chancellor seemingly sharing that the fight against inflation is over, our sense is that there is some unease at the Bank that inflation could remain stuck at an elevated level. From this perspective, the BoE pushed back against the markets, looking for 125bps of rate cuts in 2024. Nevertheless, UK yields ended the week materially lower, largely as a function of the UK tracking the more dominant moves in US markets.

Looking ahead

The past week always felt like it had the potential to be a catalyst for some substantial market movements and this has certainly been the case. In hindsight, our assessment on the Fed has been wrong and this led us to be too defensive in our thinking, with respect to interest rate duration.

We now need to reassess, though we continue to note that economic data has remained relatively upbeat, in line with our expectations. As shared above, we don’t think US rates offer an attractive risk/reward at the moment. We continue to see gilts and JGB yields as likely to rise over the medium term, as a result of underlying inflation dynamics.

In the short term, a year-end rally may see spreads in sovereign and corporate credit tighter on a broad-based rally in risk assets. However, we are wary of chasing moves too much or adding exposures at unattractive levels.

The year isn’t done yet and we would not rule out further surprises before markets quieten down during Christmas week. Jerome Powell seems happy to play Santa Claus for now, but it will be interesting to see how long into the new year the Fed can be the market’s friend, if markets get too far ahead of themselves.